Sen. Carl Levin: 'We ought to eliminate the damn synthetics'

Sen. Carl Levin chairs the Permanent Subcommittee on Investigations, and has used it not only for Tuesday's hearing on Goldman Sachs, but for previous hearings on the ratings agencies, the mortgage issuers and more. We spoke earlier today about Wall Street's casino model, the Fabulous Fab and why Levin would ban all synthetic products if given the chance.

EK: What did you think of meeting the Fabulous Fab?

CL: He's got a challenge ahead of him given some of the e-mails and some of his statements in those e-mails.

It often seemed to me that the senators and the Goldman Sachs employees were talking past one another. The senators seemed to be focusing on whether Goldman Sachs's practices were wrong, while the employees seemed content to simply try and prove that they weren't illegal.

That's true to a large extent. I think the average person's stomach turned when they heard that these guys were selling things that they internally believed were junk and crap. They were peddling products to customers when they were also betting against that product. And they didn't seem to recognize a problem with that.

The committee made the point that Wall Street has adopted something of a casino model, where it's not longer just providing capital to worth enterprises, but finding profits by making bets on different outcomes. Given that so much of the financial-regulation conversation is about preserving the value these firms offer to the broader economy, how do we add the casino model into our calculus?

The nature of Wall Street's function has changed. They still argue that they're providing capital and stimulating innovation, and to some extent they are. But there's been a significant shift here to the model where they're out for themselves. Their client is themselves. They're not market making when that happens. They're selling something in some cases out of their inventory which they're then betting against. And we need to be asking some very pointed questions about whether there's a conflict of interest when that happens.

Speaking of conflicts of interest, you've also held hearings on the ratings agencies. As many have pointed out, their failure was not only catastrophic, but in retrospect, somewhat predictable. They're paid by the banks to rate things the banks want to sell for the highest possible price. What's the solution?

The credit ratings agencies were interested in their market share and their fees and they got that if they came up with the right credit rating. So you need to give the SEC the responsibility of overseeing their standards and exercising oversight of their models, their criteria, their methodologies, their procedures. Right now, the SEC doesn't have that authority. And secondly, we might write standards that require the agencies to impose a greater credit risk under certain circumstances. For instance, if the agency doesn't have historical data, which was the case here; if the assets are being provided by a firm that has a history of high default rates or poorly performing assets; if the assets are just these references in these synthetic deals rather than a real asset.

That doesn't sound like you're addressing the fundamental conflict of interest, though.

I'd love to be able to address it and the SEC may be able to, so they should be directed to as well. But there are some things you could do to have the SEC review the standards the agencies are using in their models. To totally end the conflict, you need some kind of a random-assignment system and I'm not sure of the best way to do it. But we can put some responsibility on the SEC to give it a try.

But so far as both Goldman and the ratings agencies go, can you ever really make Wall Street work when the rewards from getting lucky at the casino are so outlandishly incredible? People will be scared for a few years, of course, but if Wall Street remains so profitable, won't the incentives for risk be stronger than the memories of regulators and raters?

As far as I'm concerned, we ought to eliminate the damn synthetics. To me, they don't serve any real purpose at all. They're just betting on something where they don't have a stake, they're not hedging legitimate risk. With other things, there's a limit. There's a finite amount of corn and wheat and mortgages. But these synthetics have no finite limit. So you literally have a gambling hall and the bets are unlimited. I'd get rid of them, and there will be an effort to get rid of them, and I will vote for it.

Congress will, as usual, spend time and money proving that regulators and our government failed again. The Wall Street boys, by and large, did what WAll Street boys are supposed to do. Government will always be later to the party and the task at hand is to make sure government gets to the party at all.

the interview I'd LOVE you to do is with George Soros to get his take on all this. Goldman Sachs, short selling, destroying of economies, housing markets crashing etc because he did a lot of the same things.

"As far as I'm concerned, we ought to eliminate the damn synthetics. To me, they don't serve any real purpose at all. They're just betting on something where they don't have a stake, they're not hedging legitimate risk."

This isn't actually true. They absolutely are used to hedge legitimate risk. Interest rate swaps, and caps and floors are legitimate hedging instruments used by banks to hedge interest rate risk.

Unfortunately, Mr. Levin has no clue how banks manage risk, and therefore would vote for bad policy out of ignorance. The "I don't really understand what's going on but something bad happened so let's just ban it entirely" attitude is often a bad way to go - there are always unintended consequences.

Look, if you want to go for limited purpose banking, eliminating the ability of banks to hold risk, I'm okay with that. But if banks are going to continue exist and take risk on their balance sheets, getting rid of hedging vehicles because some people abused similar types of products is a really bad idea.

Opacity reduces scrutiny and confers power on the few with the ability to pierce the veil. Although derivatives have indeed become extremely complex, in actuality, they are as old as the idea of finance itself. The credit derivatives market should borrow a thought from Leonardo: “Simplicity is the highest form of sophistication.”

For a clearer understanding of subprime mortgage-backed credit derivatives, visit:

Sure you can keep the synthetics. Just as long as you maintain 100% reserves for them. Oh, that makes them unprofitable? Dear me. This is a problem with economics and finance in general: when you don't know how to value something, you can be pretty sure that the final value will be neither face nor zero. Yet that's what typically goes on the books.